Tuesday, January 8, 2008

Let's Get Fiscal

In recent years, countercyclical policy - the day-to-day "management" of aggregate demand - has largely come through monetary policy action by the Fed. However, current circumstances call for fiscal policy, says Lawrence Summers:
There is now a compelling case for the president and Congress to create a programme of fiscal stimulus to the US economy that could be signed into law in the next several months.

Given the market’s prediction of Fed policy actions, the debate now is not about whether or not to provide macro­economic stimulus. That question appears to be settled. The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

Summers suggests that the government make equal payments to all income or payroll tax payers and increase unemployment insurance and food stamp benefits.

Of course, fiscal policy does not necessarily need to take the form of tax cuts, as Mark Thoma pointed out (about a month ago, in response to a similar argument from Martin Feldstein):

A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. This is just the familiar split of a change in taxes and hence disposable income into a change in consumption and a change in saving, and most of the time consumption and hence aggregate demand will increase when taxes are cut, but we can't be sure in advance how a tax cut will be used. In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

One problem with fiscal policy is the time it takes (the "lags" we talk about in Econ 202) - it requires action by the Congress and President, and once the policy is implemented, it takes time to affect demand in the economy (also an issue with monetary policy). Moreover, recessions tend to be relatively short - the average postwar recession has been 10 months long (and the two most recent ones were eight months). If we take the gloomy December employment report as an indication that a recession began in late 2007, it is likely to be over by this fall (at least as the NBER defines recessions - the unemployment rate tends to remain elevated longer). It therefore is nearly impossible to time the "stimulus" correctly to precisely "fine tune" the economy.

For example, the stimulus package proposed at the beginning of the Clinton administration was defeated in April, 1993. In retrospect, that was for the best: the NBER subsequently dated the end of the recession in March, 1991, and the unemployment rate peaked in June, 1992.

The lags are likely worse with a spending program because it would take longer for the government to spend the money than to just mail out checks. However, the stimulus is likely to miss its moving target anyway, but we would at least get some roads and bridges out of a spending program...

The Washington Post reported that the Bush administration is considering a stimulus package. Real Time Economics reports on Barack Obama's proposal. Robert Reich had an interesting idea on the subject in December.

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